chap 8 - Estimating Risk Parameters and Costs of Capital...

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Aswath Damodaran 1 Estimating Risk Parameters and Costs of Capital Aswath Damodaran
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Aswath Damodaran 2 Estimating Beta n The standard procedure for estimating betas is to regress stock returns (R j ) against market returns (R m ) - R j = a + b R m where a is the intercept and b is the slope of the regression. n The slope of the regression corresponds to the beta of the stock, and measures the riskiness of the stock. n This beta has three problems: It has high standard error It reflects the firm’s business mix over the period of the regression, not the current mix It reflects the firm’s average financial leverage over the period rather than the current leverage.
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Aswath Damodaran 3 Beta Estimation: The Noise Problem
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Aswath Damodaran 4 Beta Estimation: The Index Effect
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Aswath Damodaran 5 Determinants of Betas n Product or Service : The beta value for a firm depends upon the sensitivity of the demand for its products and services and of its costs to macroeconomic factors that affect the overall market. Cyclical companies have higher betas than non-cyclical firms Firms which sell more discretionary products will have higher betas than firms that sell less discretionary products n Operating Leverage : The greater the proportion of fixed costs in the cost structure of a business, the higher the beta will be of that business. This is because higher fixed costs increase your exposure to all risk, including market risk. n Financial Leverage : The more debt a firm takes on, the higher the beta will be of the equity in that business. Debt creates a fixed cost, interest expenses, that increases exposure to market risk.
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Aswath Damodaran 6 Equity Betas and Leverage n The beta of equity alone can be written as a function of the unlevered beta and the debt-equity ratio β L = β u (1+ ((1-t)D/E)) where β L = Levered or Equity Beta β u = Unlevered Beta (Asset Beta) t = Corporate marginal tax rate D = Market Value of Debt E = Market Value of Equity n While this beta is estimated on the assumption that debt carries no market risk (and has a beta of zero), you can have a modified version: β L = β u (1+ ((1-t)D/E)) - β debt (1-t) (D/E)
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Aswath Damodaran 7 Solutions to the Regression Beta Problem n Modify the regression beta by changing the index used to estimate the beta adjusting the regression beta estimate, by bringing in information about the fundamentals of the company n Estimate the beta for the firm using the standard deviation in stock prices instead of a regression against an index. accounting earnings or revenues, which are less noisy than market prices. n Estimate the beta for the firm from the bottom up without employing the regression technique. This will require understanding the business mix of the firm estimating the financial leverage of the firm n Use an alternative measure of market risk that does not need a regression.
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Aswath Damodaran 8 Bottom-up Betas
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chap 8 - Estimating Risk Parameters and Costs of Capital...

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